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What Is Margin Trading?

Have you ever wondered about the nuances of margin trading? Margin trading makes it possible for investors to buy more stocks than they could afford otherwise by allowing them to borrow money from brokers. Margin trading can be very rewarding or end up costing you more than you planned. Understanding how margin trading works and whether the risks are worth it can help you determine if it’s right for you.

Key Takeaways

  • Margin is the money investors borrow from brokers to buy stocks with the goal of magnifying profit.
  • Brokers lend investors money and use securities and funds within the margin account as collateral.
  • Margin trading gives you more buying power than your cash alone would.
  • Margin trading magnifies the performance of a portfolio for better or worse.
  • Make sure to fully understand margin trading before investing with it. Even though it can boost your profits, it can also make your losses more extreme.

What Is Margin Trading?

Margin trading is more flexible than other types of trading because it deals with not what you trade but how you trade. Margin is the money investors borrow from brokers to buy stocks with the goal of magnifying their profit. Investors use the borrowed money to compound upon the money they already have available to invest in more stocks than their account would have originally allowed. Basically, it allows investors to borrow money from brokers to purchase stocks that were previously not in their price range.

Cash accounts only allow you to invest the amount of money available in your account. Margin accounts, on the other hand, use what is in your account (stocks, bonds, cash) as collateral against the money you have borrowed from the brokerage firm.

Understanding Margin

In order for fair trade, brokers lend investors money and use securities within the account as collateral. Margin trading is an easy way to make fast money. These loans give investors more buying power, allowing them to purchase larger amounts of stock than they could have previously, leading to a higher profit. Margin trading requires investors to make educated guesses on the movement of particular stocks in the hopes of increasing their profits while minimizing losses. While it can make you more money, it can also increase your losses if the stock drops.

Margin trading can be volatile. If the stock you’ve invested in is doing well, you could potentially double your profit because you’ve invested not just your money but also the money loaned to you. Instead of being able to buy only 15 shares, you could now buy 30. However, if the stock you’ve invested in drops, you could double your losses because instead of only losing the money you’ve invested, you’ve also lost the money you borrowed.

Using Margin Trading

To start investing with margin, you first need to open a margin account with a brokerage firm. Margin accounts are sort of like a mortgage for a home, but instead of a home, you’re buying stocks.

Margin accounts require a $2,000 minimum deposit. This is regulated and decided by the Board of Governors of the Federal Reserve System.

If you fail to equalize the account, the broker has the right to sell off any of the collateral within the account to balance the equity ratio.

There are a few things you need to know about margin accounts. The first is that brokers can change the terms of the account and sell any collateral in the account without warning. The second is that the broker isn’t sharing the investment with you, which means they don’t share the risks with you. If the stock does poorly, it lands on you to pay back the lost money.

Finally, margin accounts come with interest rates and requirements set by the brokerage firm. The firm holds the right to change requirements at any time. For example, they can change the minimum amount they require to be held within the account.

What Are the Advantages?

Margin trading can give you more money to invest than you have readily available in a cash account. It gives you more options on buying different shares of stock, therefore giving you more buying power. It allows you to expand your investments so you don’t have all your eggs in one basket, which could be helpful if one investment doesn’t perform as well as anticipated.

Margin trading allows investors to make money more quickly if the stocks they have invested in do well. This is obviously a big incentive to invest with a margin loan, but with every big risk, there can also be a big loss.

Image via Flickr by investmentzen

What Are the Risks?

Things can get ugly fast. If the stock does not perform as anticipated, the investor still has to pay back the borrowed money, which means they lose money. Since they borrowed money to begin with, they have to pay for both the loss of their personal money and the money that was lent to them through the margin loan. This can lead to debt and even bankruptcy.

The market conditions at any given time are also a risk. If the stock you invested in drops, you now have to pay back your money along with the loan, plus any interest you’ve incurred. You’ve now lost more than you invested. If you cannot pay back the loan, the broker will sell off collateral within the account without warning or your input.

The broker can also change the account requirements at any time, and you must observe the changes even if you’ve only just been informed about them. Also, if the brokerage issues a margin call, you cannot ask for time to get the money needed. You need to pay upfront, so it could be a good idea to have a separate account with extra savings just in case.

Real-World Examples

Time to examine some real-world examples. Let’s start with one where the stock does well. If you invest $500 and you ask for a margin loan of $500, you have a combined purchasing power of $1,000. You invest that $1,000 at $10 a share, giving you 100 shares. If the price of the stock increases to $20 a share, you now have $2,000. However, you have to pay the broker back the borrowed $500.

Once you deduct the $500 of your own money that you already invested, that leaves you with a $1,000 profit when you cash out your shares of the stock. Keep in mind that this example doesn’t include the interest on the borrowed $500.

Now, let’s see what happens when the stock doesn’t do well. The 100 shares you’ve invested in drop to $5 a share. This means the worth is only $500. You sell your shares and take the remaining $500 investment to pay back the $500 you borrowed from the broker before the stock can fall anymore. However, that means you lost the original $500 you personally invested, which leaves you at a loss of $500. This example also doesn’t include interest on the margin loan, which means you have actually lost more than $500.

If you’re optimistic, you could also hold on to your stock in the hopes that it would increase again. However, this could lead to your securities in the margin account being sold to equalize the balance of the loan.

If you had invested with a regular cash account, you would have had a profit of only $500 in the first example. You would make more money faster if you use a margin account. On the flip side, if you had used a cash account in the second example, you would have broken even because you wouldn’t have any interest to pay.

If you’re considering investing with a margin account, don’t dive in headfirst; talk to people who have done this type of trading before to make sure it’s a good option. Also, learn to keep close track of your accounts to try to minimize losses if a stock you’ve invested in drops in value.

M argin trading is a valuable tool to consider when investing. It offers a higher chance of making a profit, but it can also result in you losing more than anticipated if the stock drops. It’s a catch-22, so proceed with caution.

Author:Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

What Makes Stocks Go Up?

Stock prices are determined by the marketplace and what it’s willing to pay. There is no straightforward equation that shows precisely how and why stock values behave the way they do. However, there are three main forces that determine what causes stock prices to go up and down: fundamental factors, technical factors, and market sentiment. It all boils down to supply and demand. Investor expectations drive demand up or down. If you’re thinking about investing in the stock market, read on to find out more about what makes stocks go up.

Key Takeaways:

  • Fundamental factors show how stocks are valued through earnings and price-to-earnings ratios. Fundamentals go up and down with earnings projections.
  • Technical factors are a mix of external factors that affect stock prices, including inflation and how market peers perform.
  • Market sentiment is an important but hard-to-measure factor that isn’t based on fundamentals or technical factors. Instead, it’s based on the psychology of the market.

Fundamental Factors

Fundamental factors illustrate how stock prices are valued. Long-term investors tend to focus on fundamental factors like earnings power and acknowledge that technical factors play a crucial role in stock values. Fundamental factors are based on two things:

  • An earnings base, such as earnings per share (EPS), which is calculated by dividing total earnings by the number of outstanding shares.
  • A valuation multiple, such as price-to-earnings ratio (P/E ratio). The P/E ratio is the current stock price divided by the EPS.

Owners of common stock have a claim on earnings. Earnings per share (EPS) shows this claim and is widely used to estimate a company’s value. Buyers of a company’s stock purchase a proportional share of future earnings.

Ideally, the price to earnings ratio (P/E ratio) would be similar across companies in the same industry. If the P/E ratio is too high, the stock is overpriced. If it’s too low, it’s under-priced and attractive to buyers. To calculate the P/E ratio, take the current stock price and divide it by the EPS. The value multiple is the price the market is willing to pay for the future earnings — commonly the P/E ratio. This ratio measures the current share price and how it is related to the earnings per share.

Some of the earnings may be distributed as dividends, with the balance being retained and reinvested in the company on behalf of its shareholders. Future earnings take into account current earnings and expected growth.

Public companies report earnings quarterly, and Wall Street observes those earnings. Analysts base future stock prices on earnings forecasts. If a company exceeds forecasted earnings, stock prices go up. Stock prices go down when earnings don’t meet expectations.

The Earnings Base

EPS shows the earnings base using accounting principles, but some prefer cash flow measures. Free cash flow per share also illustrates the earning power of a company.

The Valuation Multiple

The valuation multiple is forward-looking and expects earnings to increase. It’s based on the discounted present value of the future earnings stream and has two key factors:

  • The earnings base of the company is expected to grow.
  • The discount rate is used to calculate the current value of the future earnings stream.

Higher growth rates correlate to a higher multiple for the stock, while higher discount rates correlate to a lower multiple.

Discount rates go up with perceived risk. Riskier stocks earn a higher discount rate and a lower multiple. The discount rate is affected by inflation and, to some extent, interest rates. Higher inflation raises the discount rate and lowers the multiple. Future earnings have less value when inflation rates are elevated.

Interest rate increases mean higher borrowing prices and significantly affect housing-related stocks and other investments like real estate investment trusts (REITs).

Technical Factors

A mix of external factors, called technical factors, also affects stock prices. Technical factors alter the supply and demand of a company’s shares, and some may indirectly affect fundamentals. A growing economy can indirectly lead to an increase in a company’s earnings. Technical factors likely appeal more to short-term investors, who are likely to focus on inflation, demographics, and trends.

Inflation

Inflation is a major technical factor. Typically, low inflation drives high multiples or anticipated future growth. High inflation drives low multiples. Deflation is generally bad for the stock market because it results in a lack of pricing power by companies.

Economic Strength of Market and Peers

Stocks tend to follow the market within their sector or industry. Some investment firms believe that the overall market and sector performance, rather than individual company performance, determines most of a stock’s changes in value. Negative outlooks and adverse events may cause one stock to drag down other stocks in the same sector.

Substitutes

Companies compete globally for investment dollars with other asset classes. Substitutes for domestic equities include various types of bonds, commodities, real estate, and foreign equities. The demand for substitutes is hard to track, but it plays a vital role in overall stock valuation.

Incidental transactions

Incidental transactions are stock trades that are executed for reasons other than the belief in the intrinsic value of the stock. Such transactions include executive insider transactions, which are often scheduled or driven by portfolio objectives. Investors may also buy or short a stock to hedge a different investment. However, incidental transactions can move the price of stock even though they don’t indicate positive or negative sentiment toward a stock.

Demographics

Investor demographics is the subject of research that focuses in large part on two dynamics:

  • Middle-aged people tend to invest more in the market as they reach peak earning during their careers.
  • Older investors tend to lean toward more conservative investments and pull out of the market as they use their money throughout retirement.

Researchers hypothesize that greater demand from middle-aged investors will drive demand for equities and higher valuation multiples.

Trends

Stocks may move along with a short-term trend, but they may also gain momentum and popularity. Trends may also cause stocks to lose value and do what is known as reverting to the mean, a process by which asset prices and returns ultimately revert back to the average, or mean, of the overall period. Trends are hard to predict, so trendy stocks aren’t necessarily the best for long-term investing.

Liquidity

Highly liquid stocks attract a lot of investor interest and are very responsive to news and other events. Liquidity is a key factor and often garners limited appreciation.

Trading volume represents liquidity and is a function of corporate communications related to the attention the company receives from the investment community. Large-cap stocks have high liquidity since they are closely followed and heavily traded.

Many small-cap stocks aren’t on investors’ radar screens, and due to limited followers and traders, they have what is known as a liquidity discount.

Market Sentiment

Image via Flickr by AndreasPoike

Market sentiment is a complex category of stock valuation that isn’t based on fundamental factors. It reflects the psychology of investors both individually and collectively. Market sentiment ultimately affects stock prices, but it’s hard to capture in numbers and formulas. In some cases, investors overlook fundamentals like P/E ratios and value a company’s stock higher, basing the increased share value on other factors.

Many investors believe that market sentiment and technical factors affect prices on a short-term basis, but fundamentals ultimately set long-term prices.

One example of market sentiment causing prices to increase was the technology-driven bubble of dot-com stocks. Investors were euphoric and speculated irrationally. Over-leveraged investors can cause a dramatic fall in prices if the market goes in the wrong direction and they’re forced to sell stocks.

Market sentiment is often subjective, biased, and unyielding. Investors can make a sound argument about a stock’s future growth possibilities, but the market may focus on other news and keep the stock artificially higher or lower. It may take time for investors to focus back on the fundamentals.

Market finance is studied in the growing field of behavioral finance. It assumes that markets often aren’t efficient, and the inefficiency can be explained through psychology and other social science disciplines. Behavioral finance studies confirm the observable suspicions that investors tend to exaggerate apparent data and react more to losses than gains. Investors tend to weigh losses more heavily than gains and stay in a mindset that doesn’t consider all fundamentals. Behavioral finance looks at unexplainable and mysterious happenings in the market.

News

News and unexpected happenings inside a company, industry, or global economy can influence investor sentiment. World markets are increasingly connected and are affected by political issues, mergers and acquisitions, unexpected events, and product breakthroughs. The impact of news is hard to measure, but it affects the markets, sometimes instantly.

I nvestors look toward various factors depending on their investment style and goals. Short-term investors tend to focus on more technical factors. Long-term investors look at fundamentals and technical factors. Popular beliefs hold that fundamentals play an important role in setting stock prices for the long term. Those beliefs lean toward short-term changes affected by technical factors and market sentiment. Many investment professionals look toward future developments in behavioral finance, especially since traditional theories of stock valuation have limitations that cannot be explained. When investing in the stock market, it’s imperative to consider what causes stock price to rise.

Author:Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

What Is Moving Average In Stock?

Moving average (MA) is an analytical tool that provides price data by utilizing a continuously updated average price. The average is taken over a specific number of days, which could be in minutes, hours, days, weeks, months, or whatever fits the need making this a useful tool for short-term and long-term data analysis.

Key Takeaways

  • A moving average (MA) is a popular analytical tool that filters out irregularities from random short-term fluctuations and determines trend direction.
  • There are multiple ways to calculate a moving average, and it can utilize any timeframe.
  • When the price of an investment crosses over the moving average, it’s a trading signal for technical traders.
  • Even though moving averages are great as a standalone tool, they also form the foundation for other indicators, like the moving average convergence divergence, for example.
  • A simple moving average (SMA) is calculated by taking the average of a set of prices over a specified time period.
  • An exponential moving average (EMA) is an average weighted such that the more recent data is of greater import.

What Is a Moving Average?

Image via Flickr by cafecredit

Investors calculate the moving average by creating several averages of different subsets of a full data set of previous prices, and they use the MA to identify and analzye the trends of various investment options. The moving average essentially creates a rolling average price and filters out the temporary fluctuations to reduce the impacts of random short-term changes on actual trends. Investors use this information to guide future buying and selling to maximize profitability.

There’s no way to predict exactly what will happen with a stock’s price, but a tool like the moving average can help make more accurate predictions. For example, a rising moving average would suggest the stock is trending upward, while a dropping moving average would be indicative of a downward trend.

How an MA Works

Investors use a moving average to create more accurate price data by constantly updating the average price. The longer a time period used, the more the indicator will lag, or reflect the current price data. The more data points you utilize and the further you go back, the longer it will take for the MA to “catch up.” For example, a 200-day MA will have far more lag than a 20-day MA because you’re pulling prices further in the past.

Investors typically follow the 50-day and 200-day moving average calculations. Other standard time frames uses would be 15, 20, 30, and 100 days.

Which time frame you use depends on your objectives. If you’re engaging in short-term investments like day trading, for example, you’ll want to utilize a much smaller range, whereas, for an asset to be considered for long-term in your portfolio, you would use a larger range. There’s no one best time frame or any hard rules on which ones to apply. Experiment with various time frames to see which one gives you the best information as it pertains to your strategy.

Crossovers are another aspect involving the MA that investors can use. Crossovers are instances where a shorter-term (30-day) average crosses a longer-term (100-day) average when charted. If a short-term moving average goes above a longer-term moving average, this is considered a bullish crossover and indicates upward momentum. Conversely, when a short-term MA drops below a longer-term MA, that’s referred to as a bearish crossover and indicates downward momentum. When the crossover is substantial, investors tend to buy for short-term gain purposes.

Types of Moving Averages

Simple moving average and exponential moving average are the two moving averages used most often by investors. Here’s what you need to know about each:

Simple Moving Average (SMA)

The SMA is just a straight mean of the prices over a given time frame. Add up all the prices together, and then divide by the total number in the data set. If the market for a particular financial instrument is highly volatile or you need a long-term trend indicator, the SMA is a great calculation.

The number of prices you have depends on the time frame you choose. In general, the formula is:

(Day 1 + Day 2 + Day 3 + Day 4 + …)/Time frame

Exponential Moving Average (EMA)

In an effort to make moving averages more responsive to more recent information, analysts developed the exponential moving average.

Here are the steps involved in calculating the EMA:

  1. Find the SMA. Calculate the simple moving average of a certain time period in order to have a starting point.
  2. Calculate the multiplier. Analysts refer to this as the ‘smoothing factor.’ You use this smoothing factor to calculate the exponential moving average for each day by using the price, multiplier, and the previous EMA. The formula for this multiplier is (2 / (Time Period + 1)).
  3. Calculate the EMA using previous steps’ information. Use this formula to find the current EMA: {Price at Close – EMA(previous day)} x multiplier + EMA(previous day).

This allows the exponential moving average to give more weight to the most recent prices in contrast to the simple moving average, which gives all dates the same weight.

Examples of Simple and Exponential Moving Averages

As you can see in the example below, the quantity of time periods used is identical, but the EMA shifts direction much more rapidly to changing prices than the SMA. It’s this responsiveness that leads most investors to favor the EMA over the SMA.

Example of a Simple Moving Average

Let’s look at an example of calculating the SMA followed by the EMA with the following data points:

  • Week 1 : 20, 22, 24, 25, 23
  • Week 2 : 26, 28, 26, 29, 27
  • Week 3 : 28, 30, 27, 29, 28

For a 10-day simple moving average, you would take the first ten prices and simply average them to get your first SMA. After that, you would drop the oldest price and add in the newest one.

(Day 1 + Day 2 + Day 3 + Day 4 + …)/Time frame

  • The first data point would be the end of Week 2 averaging the previous 10 days:
    • (20 + 22 + 24 + 25 + 23 + 26 + 28 + 26 + 29 + 27)/10 = 25
  • For day 11, just drop off the first data point (20) and add in the 11th-day data point (28)
    • (22 + 24 + 25 + 23 + 26 + 28 + 26 + 29 + 27 + 28) / 10 = 25.8
  • Drop day 2 and add day 12 to the average.
    • (24 + 25 + 23 + 26 + 28 + 26 + 29 + 27 + 28 + 30) / 10 = 26.6 day 12 SMA
  • Drop day 3 and add day 13
    • (25 + 23 + 26 + 28 + 26 + 29 + 27 + 28 + 30 + 27) / 10 = 26.9 day 13 SMA
  • Drop day 4 and add day 14
    • (23 + 26 + 28 + 26 + 29 + 27 + 28 + 30 + 27 + 29) / 10 = 27.3 day 14 SMA
  • Finally drop day 5 and add day 15
    • (26 + 28 + 26 + 29 + 27 + 28 + 30 + 27 + 29 + 28) / 10 = 27.8 day 15 SMA
  • And, on Day 15 the final simple moving average is 27.8.

Example of Exponential Moving Average

{Price at Close – EMA(previous day)} x multiplier + EMA(previous day)

To begin finding the EMA, we start with the SMA at day 10, which was 25. Next, we find the multiplier for a 10-day moving average, which is 2 / (10+1) = 0.1818. Using these data points, we get the following breakdown:

  • Day 11 EMA: (day 11 price – day 10 SMA) x multiplier + day 10 EMA
    • (28 – 25) x 0.1818 + 25 = 25.55
  • Day 12: (day 12 price – day 11 EMA) x multiple + day 11 EMA
    • (30 – 25.55) x 0.1818 + 25.55 = 26.36
  • Day 13:
    • (27-26.36) x 0.1818 + 26.36 = 26.48
  • Day 14:
    • (29 – 26.48) x 0.1818 + 26.48 = 26.94
  • Day 15:
    • (28-26.94) x 0.1818 + 26.94 = 27.13

Here are the values lined up for easy comparison:

  • SMA: 25.00, 25.8, 26.60, 26.90, 27.30, 27.80
  • EMA: 25.00, 25.55, 26.36, 26.48, 26.94, 27.13

As you can see, the EMA is much more responsive to recent price fluctuations than the SMA.

M oving averages are a great way to stabilize price data, giving you a good idea of the trends, as long as you have a solid understanding and know the shortcomings as well as the situations where it may not be the best option. Regardless of the type of moving average, the shorter-term ones will respond quickly to price changes. While this is often good, it can generate false trend indications. On the same note, you must correctly interpret the interaction between the moving average and price action.

A moving average by itself does not accurately depict a substantial deviation or correlation, but looking at crossovers is one way to accomplish that.

Author:Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.